June, 2011

HEDGING EQUITY RISK BY PAIRING STOCKSby LARRY

In the years 2000, 2001, 2002, 2003, 2008, and 2009, stock market volatility, particularly on the downside, has created tantalizing equity bargains, yet at the cost of investor calm. Trillions of dollars worth of personal wealth have evaporated, not just once but multiple times. In 2011, we are once again experiencing stomach-churning dips in market value.

Should we then simply forego the inflation-fighting potential of common stock investing? My personal answer is "No," but it is understandable that many have come to a different conclusion.

In previous investment periods, one could hedge one's risk by setting aside a significant percentage of liquid assets in money market accounts or short-term bonds. If the market caused stocks to tumble, lowering one's allocation by 5, 10, 20% or so, this cushion of non-equities was there to draw from in raising the equities portion back to a desired level. However, historically money market accounts and short-term bonds have annually paid several percentage points of dividends. A mix of these assets plus equities could still reasonably be expected to have average annual returns of 8% or more. This is no longer the case. Today, not only do money market accounts pay almost nothing, but the hazard with bonds is that their principal will fall once inflation and interest rates begin to rise significantly again, as they eventually must to preserve the dollar's value and bonds' attractiveness in global markets. Thus, hedging one's risk with liquid non-equities threatens to substantially lower a total portfolio's growth potential, increasing the chance it will not keep up with inflation and that one may outlive a retirement nest egg or its satisfactory buying power.

It is a dilemma particularly troublesome because many of us are already smarting from terrific equity losses suffered during the past decade or so and thus are feeling a need for even greater safety, more than stocks can evidently offer.

In fact, however, two categories of equity investment are still reasonably low in risk, yet carry significant upside potential. By combining them, one can protect a portfolio almost as well as having a big chunk of it in money market funds and retain much of the excellent growth potential that stocks traditionally offer.

The first are stocks of well managed companies with superb financial strength. For example, "Value Line" each week publishes a list of several stocks rated #1 (best) for safety. (This investment service is available at most larger libraries.) A review of the current list of such highly safe stocks quickly reveals ones with increasing dividends, reasonably low debt, and, at today's prices, projected total returns sufficient to double one's investment in five years or less. A portfolio of these securities tends to grow well in bull markets and yet to decline less than the average stock during bearish period for equities.

The second relatively winning category includes stocks with comparatively low debt which are also selling for less than their per share net asset value or book value. If such stocks have debt to equity of 0.5 or below, dividend payout ratios (if they have dividends) of 0.5 or less, and a price to book value of 0.8 or less, they tend to outperform the overall domestic market by at least an extra 5% return a year. Often it is effective to sell them once up 50% or more, replacing the redeemed shares with new low price to book value bargains meeting these criteria.

Just as stocks and bonds tend to respond differently from one another at different times, so if one falls more than the other a portfolio of both investment categories can be rebalanced, selling high those that are up in price to buy low those that are down and so restore one's desired allocation levels, so too with low price to book value stocks vs. the lower risk assets that have a "Value Line" #1 safety rating.

Therefore, buying both together, a pairing of low price to book value stocks with safety first equities, can make good sense for the overall health of one's investments. Once a good accumulation of low risk assets has been achieved, more need not be bought or sold with each new low price to book value purchase or redemption, instead trading them only as necessary to maintain a preferred allocation. I like one-third of our equities to be in the safest "Value Line" category and so often invest half as much in such stocks as in those with low price to book value, as the latter, though having greater potential for gains in up markets, generally have less resilience when investors are net sellers.

This paired purchase method has worked well for investors' net worth through the turbulent years of a new century.

If interested in such an approach, here are several companies representing each technique, the first ones considered low risk but still having above average prospects, the second currently having low price to book value, but in my view possessing good potential for appreciation:

Low Risk Assets

Company

StockSymbol

RecentPrice

Price toEarnings

Priceto BookValue

DividendYield

AT&T, Inc.

T

$30.77

8.78

1.60

5.6%

Intel Corp.

INTC

$21.19

9.91

2.41

3.2%

Northrop Grumman

NOC

$64.69

9.14

1.49

3.1%

Raytheon Co.

RTN

$48.77

10.35

1.64

3.2%

Teva Pharmaceutical Industries, Ltd.

TEVA

$47.49

12.77

1.85

1.7%

Low Price to Book Value Assets

Company

StockSymbol

RecentPrice

Price toEarnings

Priceto BookValue

DividendYield

Capital Southwest Corp.

CSWC

$94.73

6.62

0.65

0.9%

Flexsteel Industries, Inc.

FLXS

$14.08

8.78

0.76

2.1%

Lakeland Industries, Inc.

LAKE

$8.22

12.76

0.56

0.0%

Sketchers USA, Inc.

SKX

$14.24

7.60

0.73

0.0%

Tellabs, Inc.

TLAB

$4.07

18.01

0.80

1.1%

One of the best times for buying both these categories of winning stocks is after there has been a market drop. More bargains are available, and their potential is greater. Of course, to do so then can be difficult, since most people are selling and one may wonder if the stocks might just keep going down. To date, however, in every historical case when patient U.S. buyers have invested at such times in our low priced assets, they have been rewarded for the apparently extra risks they have taken.

An extra plus for the hedging of stocks with other equities, in lieu of substantial holdings in bonds or money market reserves, might be dismissed as just a matter of personal style, but in fact can be substantial. A typical investor, averaging 40% in money market funds or bonds and 60% in stocks, might optimistically expect an average annual return on his or her money of around 7% or less, given the current state of things. Were that person to "make do" with liquid non-equities of only 10% of the total, putting the 30% difference into low risk stocks that balance the higher volatility of low price to book value securities, the annual return on the overall nest egg, if rebalanced periodically, could well be 10% or higher. A 3% advantage over a 40-year investing career can be huge. $10,000 invested for 40 years at 7% (if, for simplicity, in a tax-deferred account and with all redemptions, dividends, and capital gains reinvested in the account) becomes $149,750. The same initial investment at 10% becomes $453,000. Which would you prefer?

To boost one's personal nest egg further, I recommend a substantial dollar-cost-average investment in international stocks or stock mutual funds, preferably including those of the top-ten emerging market nations. In my opinion, a minimum commitment to such holdings would be 20% of one's liquid assets. These, again, can be paired with low-risk securities, such as those with a #1 "Value Line" rating for safety, to assure one's overall portfolio is not too turbulent during the markets' inevitable rough patches.

DISCLAIMER

Larry is not a professional. Don't take him seriously!

Actually, the investment article provided here is for general information only and should not be considered as professional advice, a solicitation to buy or sell any security, or the Word of God. Investors are encouraged to do their own research while considering their personal goals and circumstances, or consult their own professional financial advisors, before making investment decisions. Neither Larry nor LARVALBUG will be liable for any losses sustained by any visitor to this site.

(Disclosure statement: Larry and Val have holdings in some of the suggested assets but do not "make a market" in any of them and do not derive any direct benefit from recommending them, except perhaps for a bit of smug self-satisfaction.)